A new app marketplace for OTC derivatives that is low cost and regulatory compliant is nearly at hand, but are financial institutions and derivatives users ready for this innovative concept? DerivSource’s Julia Schieffer talks to DerivaTrust founders and market participants about this new ‘app swarm’ for trading OTC derivatives.
The application (app) game “Angry Birds” reportedly made $70 million as of this March 2011. This is one well-known success story of how app technology, purely for entertainment purposes, is taking the world by storm, and the institutional banking market is rapidly catching on to this new app trend.
Many financial apps out there are focused on providing banking research or communicating with clients but DerivaTrust Technologies is taking the app in a new direction altogether and seeks to build a cloud-based marketplace populated by millions of bespoke, trading desk created apps that enable originators and holders of exotic OTC derivatives to promote their instruments to a network of potential buyers whilst maintaining complete and secure anonymity. The DerivaTrust platform borrows heavily from the current app model and allows sellers of derivative contracts to utilize widely available application development tool kits (ADKs) to create apps that offer virtualised representations of the instrument published in the marketplace where potential buyers can search these instruments, freely download the app for analysis, and then anonymously communicate with the seller to complete a transaction privately.
Of note, however, is the fact that DerivaTrust is not an exchange or settlement facility, nor does it provide product prices. Instead, it acts as a peer-to-peer, online app discovery and anonymous communication platform that simply mimics existing, offline bilateral market practices for privately negotiated instruments, explains founder Thomas Sachson.
He said: “[DerivaTrust] is a disintermediated model where the responsibility for accuracy and quality resides with the people who are dealing with each other at arm’s length and we are just giving them the platform to find each other.”
The access to a wider network of potential buyers is the biggest benefit for users of DerivaTrust, however, the low price tag and regulation-friendly model is key to the timeliness of the introduction of this new tool. In fact, the motivation to create this app marketplace was drawn from a clear need for derivatives traders to find a more liquid, efficient, and low cost way of buying and selling of exotic derivatives at a time of increasing processing costs and a wider push towards forced exchange trading from regulators.
Increasing efficiency for the trading of non-standardised trades
As a lawyer who has worked in-house in previous years, Sachson recalls the amount of effort that is required to package up new bespoke products and create the documentation around these types of new instruments “That was when the real work happened,” he said. “It was fairly complicated and you had to spend a lot of time with the originator of the deal to make sure it was documented, represented, and agreed by all the parties accurately. And the notion that you should take all that and hand it over to an exchange and have them replicate it — seems like a lot of work and cost with a risk of something being lost in translation and errors being made.”
Market volatility and the loss of liquidity are some of the many problems market participants have faced recently and the use of DerivaTrust would help drive liquidity because the communication of the instruments via this instrument representation service allows for sellers to cast a wider net of potential buyers beyond the use of specialist brokers only. This in turn should result in the generation of better bids and underpin the value of the overall book.
“That’s one of the biggest problems that the market has – quite often people who are sitting on these instruments don’t know who else is interested in them and this is a missed opportunity in terms of liquidity,” he said.
Also the use of specialist brokers during a crisis isn’t always effective because the prices for the instrument at such times are already strained. Using a tool like DerivaTrust, brokers would be in a better position to assist clients because they themselves could cast the net further and analyse potential bids coming from a more diverse and numerous buyer universe.
For one derivatives user at a sell-side institution, this opportunity to execute a deal that might not have otherwise been dealt and ease of entry is key to validate participation in this new app marketplace.
“If enough participants post enough transactions via DerivaTrust, then it will be the place to go to provide and get information about non-standard contracts,” said the derivatives user. “For this to happen, people will need to see that DerivaTrust delivers more than the current approach, more products, more speed, more potential counterparts, and ultimately more deals done.”
“Any tool that helps the fund manager understand and analyse potential trades is going to be helpful,” said Jeremy Bezant, an independent consultant specialising in investment and trading for the buy-side. “However, fund managers are still getting comfortable with the cloud for business use, particularly when it is outside communities and counterparty networks they know. Client uptake and buy-in by a wider community will be key to the success of such a platform”, he added.
As such, DerivaTrust is only targeted for non-standardised trades that will probably never naturally find the way onto an exchange (e.g., absent a forced listing by a regulator). Based upon recent trends, these non-standardised trades are increasingly coming under regulatory scrutiny, so it was important for DerivaTrust to ensure an app based alternative to a forced listing like DerivaTrust would comply with new regulatory requirements for access to data for analysis while maintaining anonymity for users and simultaneously keeping the costs low.
“We want to keep this very simple so that market participants will voluntarily gravitate towards it and respecting existing and prospective regulatory boundaries is going to be key for doing that,” said Sachson.
And because the apps will be freely available for download, the regulators can search and download the apps, consolidate data, and analyse the size of the market without knowing who owns it. So this is really a voluntary, economically motivated model where all parties can get better data, more of it, and with regard to the regulators specifically, this is certainly more than they are getting right now,” he added.
If DerivaTrust becomes one of the acceptable methods of disclosure and meets the transparency requirements of the regulators this would be a second major driver for derivatives traders to join the DerivaTrust marketplace, said the sell-side derivatives user. The ‘private market’ and ‘potentially public policy angle’ to DerivaTrust are collectively two strong drivers that are likely to validate participating in this new app marketplace.
This is particularly important for end users. “The broker and banks with their derivatives books are going to have to increase the regulatory capital for every position they take, but the end users (fund managers, pensions, corporates, etc.) who generally use derivatives for what they were originally meant for – hedging and risk management, they are very reticent about joining the new regulatory drive because of the cost of participation,” adds Saheed Awan, the project’s UK representative. “DerivaTrust actually gives the end users the ability to transparently –- yet anonymously — interact on a peer-to-peer basis and in the process potentially obviate the need for further, more costly regulation.”
Awan continues that “the market in non-standard swaps or exotics will probably never involve banks or brokers constantly making prices for each other, instead the demand for these types of exposures will be based on particular circumstances arising periodically within the markets. In these instances, the originator of a non-standard contract has a particular interest in clearing a position and will enlist the help of a broker to find the other side. And while this type of peer-to-peer offline networking has allowed the markets to cope traditionally, the system is not terribly efficient, is costly, time consuming, and provides limited distribution and visibility for the participants. “
“Even with the emergence of electronic trading and execution through a swap execution facility (SEF), or even an exchange, neither offer advantages for non-standard derivatives given their complexities and their forced listing might actually make matters less efficient than they are today.”
“A platform like DerivaTrust, however, takes the peer-to-peer aspects of private negotiations that currently is valued by the markets and enhances it by migrating the process online. In this regard, the privacy, security, and anonymity are preserved, but the universe of potential relationships is expanded exponentially, taking the instrument discovery and negotiation process to any interested market participant in the world on a 24-7 basis. This enhanced distribution channel in turn should drive down transaction costs, improves transparency, and leads to greater liquidity and price stability.”
And since the DerivaTrust system does not engage in any actual pricing, advising, or execution on the instruments being contemplated by the parties, DerivaTrust is merely holding itself out as a secure app hosting and communications conduit — not as a financial operator. To insure that they do not veer into regulated waters, the DerivaTrust team is adamant that all execution and settlement will take place away from the DerivaTrust system at the direction of the participants themselves, just as they settle their peer-to-peer engagements currently. In this sense, DerivaTrust acts like a social networking platform like LinkedIn where properly credentialed parties can search for, discover, and exchange information with each other in a manner that is acceptable to all of the participants of the system.
As such, DerivaTrust will not seek to aggregate and analyse the financial data that flows through the system according to Mr. Sachson. “Our focus will be to build a versatile app platform and to ensure a secure communications channel for users – we do not want to process financial data for our own purposes. To do otherwise will move us away from our core tech services competency and potentially put us at odds with our customers who may not want the operator of this virtualised app platform to have greater insights into markets than they do. Bottom line, we’ll host the applications but we won’t analyse them.”
So how does it work? How much does it cost?
Financial institutions will use widely available specially designed application development kits (ADKs) to build their apps for use within the app marketplace. These tool kits have been created to cover the basic types of bilateral trades and include key components to ensure the products are easily discoverable within the app swarm once published.
More specifically, the app tool kits use the wizard approach including a series of questions that is familiar to both developers and end users. But additional coding capability is available for further refinement of the app for specific product needs, said Hieu Tran, one of DerivaTrust’s U.S. founders and chief technical officer.
“[The wizard approach] workflow is identifiable to any given application development flow, so if a customer is accustomed to developing an application for, let’s say Android, he or she would have no problem in creating those kinds of additional logical elements in the application with the ADK they are given,” said Tran.
The estimated time taken to gather the instrument information, including term sheets, creating the app based on the workflow and then coding any extra aspects will take as little as 15 minutes per contract once familiar with the ADK, said Sachson.
In terms of security, according to Mr. Tran the “app-centric” approach put forth by DerivaTrust is actually less hackable than other in-house systems due to the fact that the core trade data is stored individually in each discrete app in the cloud.
Tran explains: “It makes the data less hackable because there isn’t a centralised facility where one could hack in and see all the data,” he said noting recent news with other app providers in the gaming space have had hacking issues. Quite simply, it is harder to hack individual apps in the thousands compared to a single system, so security is actually an advantage. In addition, using an app-centric approach facilitates the anonymous communication aspect as well, which is also a major advantage, he added.
Due to the ease and time efficiency of putting together an app using an ADK, the time cost associated with creating the app to the instrument owner should be very small compared with the potential cost of preparing that same instrument for a forced listing event. As for the costs of using the DerivaTrust service, Sachson does not envision any upfront costs to the app creator or the app searcher initially. “The app creator can create and upload the app for free for the first year and try out the system. As for the potential instrument buyer, they can register with the service and search for and download a couple apps per day for free indefinitely (or pay a small fee for additional downloads), and can send as many anonymous inquiries to the app creator as they please – again for free.”
Lastly, when the app creator wishes to respond anonymously DerivaTrust will charge a small interested party “discovery” fee (e.g., one tenth of a basis point on the notional amount represented by the app) for delivering the reply message from the app creator to the app reviewer. According to Mr. Awan “the instrument owner only pays if they feel the inquiry coming in is worth replying to, and even then, only if they wish to reply anonymously through the DerivaTrust mail server. If not, there is no cost commitment to using the system, and therefore no downside. And if they ever wish to dispose of the instrument, the app creator will already have a means of communicating with parties that have previously expressed an interest in purchasing their exotic asset – which should be quite valuable in terms of generating added liquidity.”
App-Trending
Financial institutions are getting into the app market too, which shows the openness to use this technology for business purposes and especially for extending access to existing services.
Deutsche Bank launched “Autobahn App Market,” an app-based electronic distribution system that provides clients with easy access to the various electronic services on offer by the bank including research, trading commentary, interactive charting features complete with data and analytics used by the bank’s sales and trading desk. Deutsche Bank offers a ‘rates package pricer app,’ which allows users to leverage the bank’s trading desk models to price a range of derivatives, along with their ensuing risk characteristics.
The launch of the app supports the growing client demands for “instant access to information,” said Serge Marston, head of ecommerce sales at Deutsche Bank.
“Investment Banks historically respond to changing technology trends slower than consumer markets do but the Web 2.0 revolution has changed the way our clients want to go about their business, so we have adapted our model to make the electronic relationship far stronger, and simpler,” said Marston.
The greater comfort clients have with technology is also fuelling this demand for more electronic services and this trend towards technology solving client demands will only increase, he added.
And this is especially true for app-technology, said Marston.
He said: “All markets are heading towards a world of App-based delivery. The proliferation of the App model is as much a success of the simplicity of accessing the service desired as it is an awareness that we need to design systems towards what a user wants, rather than what system designers think they want; all of our system improvements are user research led and we believe this is the future for software development.”
Getting traction; Getting started
Of course in order for an app to be successful, the users must download it and this is the challenge for any app, but for DerivaTrust, it is initially looking to build the early version of the ADK around the particular needs of the system’s first participants and to this end is starting to demonstrate the system to a few institutions. “While finding early partners is an immediate focus, we think the key for generating real momentum will be the fact that most functions of the platform are free to use, as free models tends to win if the inherent value is there” according to Sachson.
While DerivaTrust waits for its first users to evaluate the platform, Sachson remains optimistic that the trend is moving from browser-based to app-centric technology combined with demands for a low-cost and regulatory compliant trading solution. According to Mr. Awan, the current operational and regulatory trends suggest that this is indeed a good time to launch a system like DerivaTrust.
According to Sachson, “The app wave is massive and the sooner the banks start working and experimenting with apps in terms of how they interact with the world and manage their data – the better off they’ll be and this is just one example of it. And the derivatives problems that we are currently facing is a great opportunity to see what this type of disintermediated approach can do.”
